Summary

Shares of KIMCO have been hit along with other retail REITs from the specter of higher rates and the Amazon effect.

KIM management is first-rate with a strong case for their business model.

The transition they are undertaking as laid out in their Vision 2020 focuses on balance sheet improvement and geography positioning.

We like their grocery-anchored strip centers that drive traffic with more insulated businesses.

We see two avenues to play it with significant upside should the credit rating of the company get upgraded to A- this year.

Thesis

Shopping center and mall REITs have been beaten down fairly substantially in the last 2 years as Amazon (AMZN) (the Death Star) consumes all of retail. However, we believe valuations are extremely cheap, and as long as net operating income ("NOI") remains at least flat, the top-quality companies will do great.

We made KIMCO Realty (KIM) our top pick of the shopping center space at the start of this year (along with Simon Property Group(SPG) in the mall space).

While the shares have taken a hit, we think the current yield of what is likely to eventually be an A- balance sheet is a rare way to generate significant yield at lower risk. The current yield on KIM shares is now over 7.5% and the price has stabilized above $14, even as interest rates on long-dated bonds have continued to go up.

Retail As An Industry

Retail continues to be pounded by the markets and we think instead of trying to pick winners and losers among those consumer discretionary names, owning from the REIT side is the best way to play a potential rebound. In the last year, the number of store closings is up 229% totaling more than 7,500 stores. That shattered the all-time record for store closings in a single-year.

We want to be highly selective in what we own in retail simply because of the disruption that is occurring right before our eyes. More than 147 million square feet of retail space is expected to go vacant in 2017 when everything is finished being tallied. But our contention is that the 'retail apocalypse' is overblown and that the current 'downturn' is really reducing the amount of low-quality assets that exist.

The United States is heavily over-malled at this point with 23.5 sq. ft per capita. This compares to Europe which averages 3.4 and Canada at 16.4, according to IHL.

But that is the media narrative which makes for good headlines. In reality, there have been more store openings than closings in 2017. What is occurring is a large rotation in the buying habits of consumers, away from many of the former leaders and towards other sub-sectors. (The following slides are from their presentation dated August 2017).

The store closings in the last year are focused on some niche, primarily mall-based retailers with a small number providing a large majority of the store closings reported. In fact, 5 chains represent 28% of the announced closings with 16 accounting for nearly half the total. The main weakness is occurring in department stores like Macy's, JC Penney's, Dillards, K-Mart, and Sears. The other major area is softgoods, namely clothing.

But again, a few larger closings produced a large effect on the results. If you look at the percentage of banners (brands) they are net opening more stores than closing, even specialty softgoods producing more net new stores.

A lot of the retail winners are businesses that focus on discount clientele. The disruption occurring in softgoods is a general shift in buying habits as investors favor discount and off-priced goods. Think of companies like TJX Companies (TJX) which focuses on selling surplus clothing and other goods a consumer would find at a Macy's department store.

bebe, The Limited, and Rue 21 in clothing and Payless Shoes in footwear are classic examples of clothing retailers with non-differentiated business models. These companies grew very fast fueled by cheap money and were quickly disrupted away by discount retailers and online stores once consumers discovered they offered nothing special.

This is illustrated well in the slide below showing the significant decline in clothing and shoes while specialty retailers have seen gains. Of course, on an absolute store count basis, the increases in specialty weren't even close to offsetting the declines in clothing.

Back to KIMCO...

The business model has to center on "being relevant and a necessity".

KIMCO makes the case that their retail base is growing store count, and not reducing. Plus, they are highly diversified across tenants with only 14 having total ABR exposure more than 1.0%. The only large tenant we think could create some risk for the company is Bed, Bath, and Beyond.

Much of their shopping centers have grocery-anchored stores which are the most insulated from Amazon (unless the store is owned by Amazon as is the case with Whole Foods).

Management's optimism has certainly increased in the last few quarters. The goals of rent increases appear optimistic but they have been realized, despite the closings and churn.

Most Recent Results

First Quarter Highlights:

Funds from operations (FFO) increased 5.4% yoy to $0.39 per diluted share, compared to $0.37 a year ago.

Same-property net operating income increased 2.6% compared to the first quarter of 2017.

Pro-rate occupancy edged up to 96.1%, up 10 bps qoq but 80 bps over the last year.

Produced new leasing spreads of 15.6%, the 16th consecutive quarter for increasing rental rates for new leases were above 10%

They disposed of 21 shopping centers totaling 2.3 million square feet for a gross sales price of $219.5 million.

Issued an additional $34.5 million of 5.25% class M cumulative redeemable preferred stock while repurchasing 1.6 million shares of the common.

Repaid $161.5 million of consolidated secured debt including $100 million due 2019.

The portfolio continues to improve with their average base rents up 19% to $15.69 from $13.18. Meanwhile, they are making progress on redevelopments and new developments with their latest project, Dania Place I, currently 93% pre-leased.

Management sees significant demand from off-price companies, health and wellness, specialty grocers (they just signed Sprouts to anchor one of their newer projects), home improvement, furniture, arts and crafts, and entertainment.

The majority of the properties sold during the quarter were located in the midwest, consistent with their geographic focus on the south and west. They did realize a cap rate on the lower end of what they expected, reflective of strong investor demand despite the media headlines. There appears to be strong demand by private capital for commercial real estate. Management noted that they are seeing five to six bids per property compared to an average of three to four in 2017.

On the call, they noted that they have another $500 million plus under contracts with an accepted offer. They are maintaining their full-year guidance for both net sales volume and cap rates.

From the call:

Yes, we'll continue to see a majority of the dispositions coming from the Midwest. We'll continue to prune assets out of other regions throughout the country. But we are very much focused on reducing the exposure in the central part of the country and ensuring that the coast become a more prevalent part of the portfolio.

Focusing on coastal geographies is not without its risks, but in general, we point to a lack of real estate along with more dense and wealthy populations. No strategy is without risk, but we believe as a premium shopping center business, the focus on the coasts (primarily) falls in line with their vision.

Vision 2020

The company has laid out their vision of their goals to be reached by the end of 2020. In terms of NOI, they want to achieve 140-165 bps of organic growth through rent increases, another 110-160 bps through leasing and value creation, 100-150 bps from redevelopment activities, and 85-110 from new development for a total of 435-585 bps of annual growth.

The below chart shows their walk through on achieving $1.2 billion of NOI by 2020.

The development/redevelopment pipeline is a large portion of that growth by focusing on NAV creation. The current total pipeline is approximately $800 million of which $370 million is value creation producing another $50 million in NOI.

Over the next few years, they will be focusing heavily on redevelopment committing $150-$175m in annual capex for incremental returns of 8% to 13%. This compares to the prior four years where they averaged just $70 million in capex per year. Once these investments are completed, look for a small but incremental inflection in NOI.

Very Strong Balance Sheet

The balance sheet is where we spend a large amount of time. Focusing on the bond market moves is a great way to assess future credit prospects. While we typically like to find non-investment grade issuers who we think are likely to move up to investment grade based on management moves and improvements in the company's P/L, KIM has a strong low-investment grade rating of BBB+.

In management's 2020 vision, they have a stated goal of reaching an A- credit rating (A3 for Moody's). During the quarter, they conducted several transactions that point to progress on that front. They issued $850 million in unsecured bonds with $500 million at 3.3% and $350 million at 4.45%, with a weighted average life of 16.7 years. They also refinanced a mortgage on their Tustin, CA property at a 4.15% rate compared to 6.9% previously. Lastly, they issued some new preferred stock with a perpetual maturity at a 5.125% coupon.

Most of the proceeds were used to pay off higher-coupon debt. For example, the 5.125% preferred offering was used to pay down their 6% preferred. The 3.3% bonds paid off 4.3% issues that were due this year while also repaying an outstanding balance on their credit facility. As a result of the moves, their weighted average debt maturity is now 10.8 years, one of the longest in the REIT space. With the refinancings, they now have less than $100 million in debt due this year with over $2 billion of liquidity.

Overall, net debt to adjusted EBITDA is at 6.3x on a consolidated basis and 7.4x when including the preferreds. This is largely in line with the peer group average.

From the first quarter call:

Fourth, further improve the balance sheet to enable us to reposition our portfolio for the future and provide safety for a steady and reliable dividend. We ended the first quarter with consolidated net debt-to-recurring EBITDA at 5.7 times and only $8 million outstanding on our $2.25 billion unsecured line of credit.

While we are proud to be only one of a dozen in Triple B Plus or BAA1 rated REITs, we continue to seek opportunities to improve upon this rating. We recognize there are some challenges ahead as we move to execute on these initiatives and are confident that we'll prepare to meet them head on.

For example, our 22 Toys "R" Us locations which represent 90 basis points of our total annual base rents and a 130 basis points of occupancy are already seeing significant demand from our list of growing retailers that are in search of high-quality locations.

The Toys R US bankruptcy is one of the largest overhangs for the stock. If they can show significant progress over the next few quarters on re-leasing those spaces, we think the stock could lift significantly higher.

Management also wants to reduce net debt to recurring EBITDA to just 5.5x from 5.7x and on a look-through basis, to 6.5x from 7.2x by 2020. The key will be the contribution of revenue (and EBITDA) from their signature series development projects, which are at various stages of completion. In addition, the re-leasing of now empty spaces from Toys R US and others reducing store count will also assist in producing moderate EBITDA growth.

There are two other retail REITs that have an A credit rating are Federal Realty Inv (FRT) and Simon Property Group. FRTs total debt-to-EBITDA ratio is very similar at 6.1x compared to 6.2x for KIM using Q4 2017 numbers. SPG, which has a credit rating two notches above KIMs at A, has a total debt to EBITDA of 5.1x. Should KIM reduce their net debt to EBITDA ratio to 5.5x as they target, they would be in the range of SPG and well below that of A-rated FRT. And in our opinion, well deserving of their upgrade.

Still A Solid Buy

From a P/FFO perspective, the shares of KIM are dirt cheap, even though they have come off their lows.

But the shares are a yield-play, which along with the sentiment regarding retail has been their Achilles heel. The correlation between the yield of the ten-year and the dividend yield of KIMCO has been high the last couple of years. Given KIMCO's balance sheet, we assess a spread over Treasuries that we think is warranted.

The effective yield of the BofAML US Corporate BBB Index is 4.35%, a spread over the 10-year of ~130 bps. KIM shares yield 7.34%, for an effective spread of ~430 bps. Of course, that is for the common which is far lower on the corporate structure ladder.

However, the company is well on its way to an A-credit rating. That would shave another 38 bps off the benchmark yield. Right now, investment grade bonds are bulged in the BBB-rated space. There are now more BBB-rated bonds than all other investment grade ratings combined. An upgrade to A- would separate KIM from the pack and would lift a massive overhang on the shares.

We think the spread of these shares, at 7.34% trailing yield (7.96% forward yield), is substantially too wide and we have a medium-term target of 6%, at this interest rate regime. Meaning, should interest rates stop rising from here the shares should trade at a 6% yield at a BBB-rated level. At an A- credit rating, we think the shares should trade even lower, between a 5.25% and 5.50% yield. FRTs dividend yield is just 3.45%, about half of that of KIMs. That disparity should not exist given what we think are very similar quality companies. While FRTs FFO growth is higher at ~6% (compared to KIMs ~3%), the valuation is also much higher at a P/FFO of 18.8x vs. 10x for KIM.

If our thesis plays out and the balance sheet is upgraded, we see a price between $20.36 to $21.33 in the next year for potential upside of 42%.

Opportunities As Well In Some Of The Preferreds

For those investors that do not like to buy individual stocks but do purchase individual preferred stocks and baby bonds, we like KIMs preferred stocks. This is especially the case of their preferreds that are now callable.

The I-shares are currently callable (3/20/2017) but trade $1.15 below par offering with a high yield to call.

The K-shares are trading around $22 and went callable in December 2017.

The I-shares were partially redeemed in Sept 2017 and management on the call noted that they plan to take the rest out. The shares shouldn't be trading this far below par, especially for an investment grade balance sheet.

We really like the KIMCO preferreds. The likelihood of them being called is extremely high. In fact, they explicitly said as much on the call:

Chris Lucas

Glenn, a quick one for you. You took out more than half of the 6% preferred and there is still remaining. What's your plans for the remainder of that and why didn't you fully redeem out that $400 million preferred?

Glenn Cohen

At the right time, we'll redeem the balance of those 6% preferred. Again, we are trying to balance total look through of consolidated net-debt-to-EBITDA including it with preferreds. And when we went to the market, we went with a very aggressive rate, 5 and 8 [ph] rate was a pretty aggressive. So, we took out what we could get done at that point. I mean, we clearly got to the debt market and replace it at a lower rate but that's just going to put more pressure on consolidated net-debt-to-EBITDA. So, we will take it out at an opportunistic point.

The KIM-I are the most likely to be called since more than half were already called and they have the highest coupon. The upside is greater, however, on the KIM-K and KIM-J, both of which trade further below par. Given that the company just issued the L and M shares at 5.125% and 5.25% yields, respectively, there is clearly an ability to lower their 6% coupon rate. The refinancing of preferred stock is a given at 1% but the rule of thumb is often 75 bps.

If they get a credit upgrade to A-, then the ability to lower that coupon even further increases significantly and a call would be inevitable. The I-shares if held for a year before they are called would generate a total return of 11%.

Conclusion

KIM is our favorite shopping center REIT and has been for some time. The price appears to have made a bottom just under $14 and has rallied some back to near $15. Even at the higher price, the yield is extremely attractive when compared to BBB-rated debt. Our base case for the common is 300 bps above the 10-yr given the likely credit upgrade that should come within the next twelve months. At that level, the shares would yield around 6% for a share price of $18.66.

Management has been de-risking selling assets in less desirable geographic locations in the midwest in favor of coastal and southern developments. The proceeds from these asset sales are funding their redevelopment and development projects while they reduce leverage.

We like the positioning and value that KIM offers on the common, but for those that dislike individual common stock positions, there is a great opportunity in the preferreds that we think offer potential double-digits yield to call.

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